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What Is a Self-Directed IRA?


[Updated: Nov 16, 2020] Oct 25, 2019 by Matt Frankel, CFP
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Individual retirement accounts, or IRAs, have some fantastic tax benefits and are excellent vehicles to save for retirement. However, if you open an IRA with a broker, you're generally limited to stocks, bonds, cash investments, and related investment vehicles like mutual funds.

There's a lesser-known alternative to the standard IRA, known as a self-directed IRA. This is a tax-advantaged retirement account designed to let investors put their retirement savings to work with non-traditional assets.

Here's an overview of what a self-directed IRA is and some of the pros and cons of using one for your own retirement savings.

What is a self-directed IRA?

In simple terms, a self-directed IRA is an individual retirement account that lets investors hold non-traditional investments with their retirement money. For example, a self-directed IRA can be used to hold real estate assets. These IRAs have some big advantages over traditional options.

Diversification is one advantage -- many investors aren’t comfortable with all of their assets being invested in stocks and bonds.

It’s also a great way to shelter non-traditional investments from taxation. For example, if you own cryptocurrencies through an IRA, you won’t owe a dime in capital gains tax if you sell. The money stays in the self-directed IRA, tax-deferred (or tax-free, in the case of a Roth IRA), until you withdraw it.

What types of investments can you make in a self-directed IRA?

You can hold stocks and bonds in a self-directed IRA, just as you could with a standard IRA. However, the main reason most investors open self-directed IRAs is to invest in assets that are otherwise unavailable to IRA investors.

The possible investments you can make in a self-directed IRA include (but aren’t limited to):

  • real estate, including land;
  • gold, silver, and other precious metals;
  • cryptocurrencies; and
  • investments in private businesses, such as a passive interest in a partnership.

There are some things you cannot buy in a self-directed IRA. Just to name a couple of the most common examples, you can’t own collectibles or jewelry through your account (if you’re unsure about the line between precious metals and collectibles/jewelry, ask a tax professional with self-directed IRA experience). You also can't own any real estate assets that you or any of your relatives plan to live in.

Tax benefits of a self-directed IRA

Self-directed IRAs have the same general tax benefits of traditional or Roth IRAs, but they’re worth discussing here in case you aren’t familiar.

In a nutshell, money you contribute to a self-directed IRA may be deductible on your tax return, depending on your income and whether you or your spouse have a retirement plan from your employer. Investments grow on a tax-deferred basis (meaning no capital gains or dividend taxes each year), and when money is eventually withdrawn from the account, it's considered taxable income.

With a Roth self-directed IRA, contributions aren't tax-deductible. However, investments grow tax-deferred and qualifying withdrawals are 100% tax-free.

Drawbacks of self-directed IRAs

While there are some pretty big diversification and tax advantages to self-directed IRA investing, there are some drawbacks, as well.

Specifically, some of the rules involved with self-directed IRA investing can make these accounts seem like more trouble than they’re worth.

For example, if you buy an investment property through a self-directed IRA, you’ll need to funnel all income and expenses involved with the property through the IRA. If the property needs a quick repair, the funds need to come out of the IRA -- you can’t just write a personal check to the vendor.  

How much can you contribute to a self-directed IRA?

Here’s one of the potential downsides to investing in a self-directed IRA, especially if you want to invest in real estate through the account. The IRS sets contribution limits for IRA investors each year, and for the 2019 tax year, the limit is $6,000 for investors under 50 and $7,000 for investors age 50 or older. This is a per-investor limit, not per account. As you might imagine, it can take a long time before you’ll have enough cash to buy a property.

What’s more, it can be difficult to finance real estate if it’s held in a self-directed IRA. Without getting too deep into a discussion of investment property financing, the only way to finance an investment property in a self-directed IRA is with a non-recourse mortgage (meaning the lender can't go after your other assets if you don’t pay). These generally require 40%–50% down, so it can take a lot of cash to buy an investment property through an IRA.

For this reason, when investors open a self-directed IRA to buy real estate (or any other expensive assets, for that matter), they generally roll over a large balance from an existing IRA.

How can you open a self-directed IRA?

You won’t be able to open a self-directed IRA through a traditional brokerage. You’ll need a trustee or custodian -- and likely one that specializes in self-directed IRAs.

Be sure to choose a reputable company, and ask a tax professional or a financial planner to help point you in the right direction.

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